Lender must approve extra principal payments; more

LewSichelman

WASHINGTON (MarketWatch) -- Issues on people's minds: Can my lender refuse to accept the extra principal payments I send in each month and how exactly does the capital-gains exclusion on home sales work?

I started prepaying my owner-financed mortgage in January by making one regular payment and adding the next month's principal payment to it. By June, I had paid six regular payments, each with the next month's principal payment added to it. My lender cashed the first two checks with the extra principal, then refused to cash the March and June payments, threatening to foreclosure if I don't stop prepaying. There is no pre-payment penalty in my note. Do you have any documentation that I can get or is there anything published that I can purchase to back up this method of pre-payment. Sue Nance, SecretPlace Real Estate Shoppe Inc., Surf City, N.C. See previous Realty Q&A.

Answer: I'm a tad confused here. First you say you have an owner-financed mortgage, which tells me you are dealing with an individual who sold you the property and took back the paper. Then you say "my lender," which indicates you are dealing with a business entity of some sort, either a mortgage company, an investor who bought the loan from your lender, or a company known as a "servicer" that administers the loan on behalf of your lender or investor.

Whomever you are dealing with, the language in the note rules supreme, so read it very carefully. Typically, it will say whether the lender will accept prepayments of any kind.

According to attorney Robert Jackson of Jackson & Associates, a law firm in Irvine, Calif., the note also usually specifies the exact order in which funds will be applied. Generally, extra payments are used first to satisfy any late fee or other outstanding charges. If there is anything left, it is applied to outstanding interest. And then, what's leftover after that is applied to principal.

If the note does not mention prepayments, then state law applies. Every place is different, so you'll have to check with the agency in your state that regulates mortgage lending. But Jackson says that in California, absent language to the contrary, the law requires lenders to accept prepayments. The law there also sets a limit on penalty lenders can charge for prepayment of principal.

By the way, there is nothing wrong with your methodology, but you made a classic mistake when you assumed the lender would be happy to take your money early. That's just not the case. Often, lenders and investors base the interest rate on the loan on their yield over the term of the loan. So when the loan is paid back earlier than expected, their profit isn't as great.

Anyone who is even thinking about prepaying a mortgage in this or any other manner should make sure going in that the lender will allow you the "privilege" of doing so without penalty. Many lenders will oblige and some even provide check boxes on monthly billing statements for just such a purpose.

Another caution: Keep accurate records. Keep a log, and check periodically to make sure the extra money is being credited to principal and not escrow. And remember, a payment of any succeeding month's principal does not eliminate the need to make your next month's payment.

That said, I seriously doubt the lender would foreclose. In this day and age, someone who is being paid on time would find it extremely difficult for a court to go along with an argument that he wants to boot you because you are paying too much. In fact, I wouldn't at all be surprised if a judge didn't force him to accept your extra payments.

The best source of information that I know of for prepaying a mortgage by making extra payments to principal every month is the "Financial Real Estate Handbook" published by the Financial Publishing Co. That's where I first learned about it in the early 1980s.

Regarding the capital-gains tax exemption on primary residences, I read that to qualify for the exemption you must have owned and occupied a primary residence for a total of at least two of the previous five years. The two-year requirement is clear to me: Own and occupy. But should we have to own the residence for at least five years before the sale to qualify, or can we qualify after two years and one day of ownership and occupation? Jean-Marc Cabrol.

A: Simple question, simple answer. Homeowners qualify for the full $500,000 exemption ($250,000 for individual taxpayers) after two years of occupancy. In other words, no, you don't have to own and live in the place for five years prior to the sale to qualify for the write-off, just two. If you closed on and moved into your principle residence on Jan. 1, 2005, you'd qualify if you sell anytime after Jan. 1, 2007.

You don't even have to live in the place for two continuous years. Cumulatively is good enough to meet the two-out-of-five test.

The losses from sale of stocks and stock options can be offset by gains in the sale of real estate. Does it matter if gains are short-term or long-term gains? Mila.

A: Yup. Gotta be long-term.

Feedback

"In your column of July 8, your lead indicated that the problem was what to do when the house value is less than the mortgage. But the first letter described someone who sounded like they could not make the mortgage payment, whether or not the mortgage amount was higher than the house value," writes Kevin Coughlin, Wilmington, N.C. See previous Realty Q&A.

"One obvious answer to the problem of what to do when the house value is less than the mortgage is just stay in the home and make the payments. You still have a place to live, and the value will probably catch up sooner or later."

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